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The Factors Behind Construction Risk

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The largest municipal bankruptcy in U.S. history, caused by bonds issued for the construction of sewers in Alabama's Jefferson County, and the looming bankruptcy of Stockton, Calif., have brought home the reality that construction professionals cannot continue to remain oblivious to the economic risks associated with construction projects and programs. My position is that the construction industry's dependence on government support prevents stakeholders from clarifying the risks in construction and coming to an agreement on how the construction economy can remain systemically sustainable.

A recent book, "Modern Construction Economics" (Routledge, 2010), illuminates some of what I believe is behind the industry's predicament. Edited by Gerard de Valance, the authors describe the fragmented nature of construction, with its multitude of contracts, subcontracts and delivery methods, causing the players to externalize risks rather than holistically define risks and risk exposure of construction-project stakeholders. Part of the problem is that construction managers are often far removed from the overriding economic drivers of construction projects and programs. The sobering message of the book suggests there is no single economic theory universally understood by participants in the construction industry. The authors call on researchers and practitioners to take a deeper look at the purpose of what they do and ground their actions in coherent economic theory that is methodically tested from time to time with credible evidence, rather than the opinion surveys commonly relied upon by academic researchers in construction.

PATIL

"Modern Construction Economics" also addresses the need to recognize the inherently incomplete nature of transactional contracts—typical short-term agreements between owners, general contractors and subcontractors—because of information asymmetries (i.e., one party has information the other lacks). The limitations of prevailing approaches to tendering or bidding are acknowledged.

Precision v. Accuracy in Bids

However, this important book misses the fact that a "bid" (and the budget as well) is a business decision that reflects the best judgment of the decision-maker and the "precision"—not the "accuracy"—of the cost estimate. Precision merely speaks to the proximity of various estimates to each other. Accuracy, on the other hand, speaks to the proximity of the estimate to the "true" cost. With numerous variables affecting the true cost of a project and the uncertainty inherent in implementation, an estimate can be accurate only in theory and almost never in practice. Therefore, pricing of work involves performance-related uncertainty and entrepreneurial judgment.

The recent emphasis on "collaborative" delivery methods and public-private "partnerships" to infuse private funding into major construction projects has not realized their full potential because, instead of clarifying risks and risk exposure of the stakeholders, the attempts to "share" risks have muddied the waters and made the initiatives politically unpalatable. Attempts to seek certainty through regulation also are going nowhere because of the fiscal challenges coupled with the inability to produce accurate estimates

"Modern Construction Economics" has another shortcoming: it ignores the critical role of how project identification, economic feasibility, development, design and construction-work processes are organized in firms, markets and institution. Without addressing the critical dimension of the organizational competence of firms, markets and institutions, proper risk management will remain a pipe dream.

Construction contractors, designers and researchers need to participate in the discussions of economic theories that drive their work and acknowledge the fact that the "base multiplier theory" of government spending is intended to "stimulate"—not "run"—the economy. Exactly who bears the risks needs to be better understood if the construction economy is to remain sustainable. In the long run, excessive reliance on public spending to run the economy poses the risk of undermining the very idea that necessity is the mother of innovation and creates disincentives for industry, government and researchers to seek clarity in identifying and allocating risks. 

Shekhar Patil, a consultant and Minnesota State University, Mankato, faculty member, focuses on risk management for innovation rather than risk transfer. He can be reached at shekhar.s.patil@gmail.com.

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